There are many great trading strategies out there, and purchasing books or courses can save you time finding one that works, but trading can also be a "do it yourself" career. Many traders spend hundreds or even thousands of dollars looking for a great trading strategy, but building your own can be fun, easy and surprisingly quick. (See also: Forex Automation Software for Hands-Free Trading.)
To create a strategy, you'll need access to charts that reflect the time frame to be traded, an inquisitive and objective mind, and a pad of paper to jot down your ideas. Then you formalize these ideas into a strategy and "visually backtest" them on other charts. In this article, we go over the process from start to finish and offer important questions to ask along the way. Once you're done, you'll be ready to start creating your own strategies in any market and on any time frame.
Time and Place?
Before a strategy can be created, you need to narrow the chart options. Are you a day trader, swing trader or investor? Will you trade on a one-minute time frame or a monthly time frame? Be sure to choose a time frame that suits your needs. (See also: Multiple Time Frames Can Multiply Returns.)
Then you'll want to focus on what market you'll trade: stocks, options, futures, forex or commodities? Once you've chosen a time frame and market, decide what type of trading you'd like to do. As an example, let's say you choose to look for stocks on a one-minute time frame for day-trading purposes and want to focus on stocks that move within a range. You can run a stock screener for stocks that are currently trading within a range and meet other requirements such a minimum volume and pricing criteria.
Stocks, of course, move over time, so run new screens when needed to find stocks that match your criteria for trading once former stocks are no longer trading in a way that aligns with your strategy.
Creating and Testing Strategies
Creating a strategy that works makes it much easier to stick to your trading plan because the strategy is your own work (as opposed to someone else's). For example, suppose that a day trader decides to look at stocks on a five-minute time frame. She has a stock selected from the list of stocks produced by the stock screen she ran for certain criteria. On this five-minute chart, she'll look for money-making opportunities.
The trader will look at rises and falls in price to see if anything precipitated those movements. Indicators such as time of day, candlestick patterns, chart patterns, mini-cycles, volume and other patterns are all evaluated. Once a potential strategy is found, it pays to go back and see if the same thing occurred for other movements on the chart. Could a profit have been made over the last day, week or month using this method? If you are trading on a five-minute time frame, continue to only look at five-minute time frames, but look back in time and at other stocks that have similar criteria to see if it would have worked there as well. (See also: Momentum Indicates Stock Price Strength.)
After you determine a set of rules that would have allowed you to enter the market to make a profit, look to those same examples and see what your risk would have been. Determine what your stops will need to be on future trades in order to capture profit without being stopped out. Analyze price movement after entry and see where on your charts a stop should be placed. When you analyze the movements, look for profitable exit points. Where was the ideal exit point, and what indicator or method could be used to capture most of this movement?
When looking at exits, use indicators, candlestick patterns, chart patterns, percentage retracements, trailing stops, Fibonacci levels or other tactics to help capture profits from the opportunities you see. (See also: Trading Psychology and Technical Indicators.)
Depending on how often you want to look for strategies, you can look for tactics that work over very short periods of time. Often, short-term anomalies occur that allow you to extract consistent profits. These strategies may not last longer than several days, but they can also likely be used again in the future. (See also: Making Sense of Market Anomalies.)
Keep track of all the strategies you use in a journal and incorporate them into a trading plan. When conditions turn unfavorable for a certain strategy, you can avoid it. When conditions favor a strategy, you can capitalize on it in the market.
Additional Things to Consider
Using historical data and finding a strategy that works will not guarantee profits in any market. It is for this reason that many traders do not backtest their strategies, applying the strategy on historical data. Instead, they tend to make spontaneous trades. This is a lack of due diligence. It's important to know a strategy's success rate, because if a strategy never worked, it is unlikely to suddenly start working today. That's why visual backtesting – scanning over charts and applying new methods to the data you have on your selected time frame – is crucial.
Many strategies don't last forever. They fall in and out of profitability, and that's why one should take full advantage of the ones that still work. If something has worked for the past few months or over the course of the past several decades, it will probably work tomorrow. But if you never looked to the past to test that strategy, you might not even realize it was there, or you might lack the confidence to apply it in the markets tomorrow to make money. Knowing that something has worked in the past will thus also give a psychological boost to your trading.
Trading needs to be done with confidence (not arrogance), and being able to pull the trigger on a position when there is a set-up to make money will require the confidence that comes from looking to the past and knowing that, more often than not, this strategy worked. (For more, see: Backtesting: Interpreting the Past.)
Keep in mind you do not need to look for strategies that work 100% of the time. In fact, if you do, you'll likely find no workable strategies. Simply look for strategies that net a profit at the end of the day, week or year(s), depending on your time frame.
The Bottom Line
Strategies fall in and out of favor over different time frames; occasionally, changes will need to be made to accommodate the current market and our personal situation. Create your own strategy or use someone else's and test it on a time frame that suits your preference. By looking back, you can give yourself some great starting points to make more money and avoid losses as you become more experienced. Track all strategies that you use so that you can use these strategies again when conditions favor it. (For additional reading, check out: Using Technical Indicators to Develop Trading Strategies.)